Economics 1021 Chapter 16 Notes

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School

Western University

Department

Economics

Course

Economics 1021A/B

Professor

Jeannie Gillmore

Semester

Fall

Description

Chapter 16: Externalities
Externalities in our Lives
 Externality: A cost or a benefit that arises from:
o Production and falls on someone other than the producer
o Consumption and falls on someone other than the consumer
 Negative externality: An externality that imposes a cost
o Of production:
 Traffic congestion during rush hours
 Pollution of air, water, and land
o Of consumption:
 Smoking
 Noisy parties and concerts
 Positive externality: An externality that imposes a benefit
o Of production:
 Honey farming
 Education
o Of consumption:
 Vaccinations
 Restoration of historical artefacts and buildings
Negative Externality: Pollution
 Private cost (of production) : A cost that is borne by the producer of a good or service
 Marginal private cost (MC): The cost of producing an additional unit of a good or service that is borne by the
producer of the good or service.
 External cost: The cost producing a good or service that falls on the people other than the producer
 Marginal external cost: The cost of producing an additional unit of a good or service that falls on the people
other than the producer.
 Marginal social cost (MSC): The marginal cost incurred by the producer
and everybody else whom the cost falls
o MSC = Marginal private cost + Marginal external cost
 When an industry is unregulated, the amount of created pollution depends
on the market equilibrium price and the quantity of the good produced.
o Since firms are only concerned about the costs they will bear, the
MC curve and the MSC curve are different.
o Equilibrium is inefficient, since MSC does not equal MSB.
o Grey triangle shows the deadweight loss Efficient equilibrium x (MSC – MC) x ½
 Property rights: Legally established titles to the ownership, use, and disposal of factors of production and goods
and services that are enforceable in court
o If a firm polluting a river happened to own it and the homes by the river, the firm now faces the cost of
their pollution (forgone rent from the people who live by the river).
o Since the cost of pollution is taken by the firm, MC = MSC and the equilibrium is efficient.
 Coase theorem: Proposition that if property rights exist, if only a small number of parties are involved, and if
transaction costs are low, then private transactions are efficient.
o Transaction costs: Opportunity cost of conducting a transaction.
o There are no externalities because the parties take all the costs and benefit into account.
o It does not matter who has the property right.
o If the residents own their homes and the river, the firm must pay a fee to the homeowners, and so the
firm faces an opportunity cost of the pollution just the same.
o However, in most situations, transaction costs are too high to apply the coase theorem.
 Possible government actions in a market with external costs:
o Pigovian taxes: Taxes